Paying a Market Salary

For those small business owners that pay their spouse a salary and for those that leave some profit in their company or trust, the Supreme Court decision in the IRD v Penny & Hooper Case should be of interest to you.

The case concerned two orthopedic surgeons that changed their businesses to be operated through trusts. They paid themselves low salaries so that the majority of their profit was taxed at the trust tax rate of 33% instead of the top personal tax rate at the time of 39%. The IRD sucessfully argued that the trusts should have paid the surgeons a 'market salary' and that not doing so was tax avoidance.

The main reason for the Courts decision was the lack of commercial reality. In other words, there was no way those surgeons would have worked for the trusts for the salaries they were paid if they didn't also control those trusts.

Following that Supreme Court decision, the IRD have targeted service providers where less than 80% of profit has been returned to the individual service provider. Now that the top personal tax rate is the same as the trust tax rateof 33%, there are now far fewer situations where there is any advantage gained from paying a lower than market salary. If there is no tax advantage, then there can be no tax avoidance.

However, I do wonder whether this decision will have any impact on the payment of a salary to a spouse. Several of our clients pay part of their profit to a spouse that helps out with the administration of their business. The tax benefit of doing this arises when your spouse has no other income so is on a much lower personal tax rate then you so it is desirable to pay as much profit to your spouse as possible.

With the decision regarding market salaries, it raises the possibility that the IRD could look more closely at the amount of salary paid to spouses. So, to avoid unnecessary IRD scutiny, the amount of salary paid to a spouse should be in line with the services they provide. My advice is to keep a timesheet of their hours spent working for the business and a job description detailing their role so that their salary could be justified in the event of an IRD audit.

Disclaimer: The above article is general in nature and we recommend you seek professional advice tailored to your specific personal situation.